A Useful Definition of "Deflation" - the Principle of Charity

Some prices are falling, some are falling quickly, and some are still rising. Whether we've got deflation, and how much deflation we've got, depends on what you include in the index, with what weights, and over what time period. Do we include asset prices for example? It depends on how you define the word. Now you can define "deflation" to mean anything you want, but some definitions might be more useful than others.

We fear deflation because aggregate demand for newly-produced domestic goods and services depends on the real rate of interest. The real rate of interest is the nominal rate minus expected inflation, and since deflation is just negative inflation, the real rate of interest is the nominal rate plus expected deflation. We fear deflation because deflation causes expected deflation, which raises the real rate of interest, which lowers aggregate demand, which causes excess supply and a recession, which causes deflation to increase. If we are close to the lower bound on nominal interest rates, this is something we ought to fear.

So right now, the best definition of "deflation" is the definition which maximises the truth-value of the sentence: "Aggregate demand for newly-produced domestic goods and services depends on nominal interest rates plus expected deflation". In other words, we should choose a definition of deflation which would provide the best fit in an estimated aggregate demand equation. We should define "deflation" using economists' theory plus the philosophers' Principle of Charity

http://en.wikipedia.org/wiki/Principle_of_charity

Let's see how this meta-definition works.

If the price of antique furniture is falling, does that count as deflation? No, because even though people would postpone buying antique furniture if they expect prices to fall, this has no effect on current output and employment, because nobody produces antique furniture. (OK, the services of antique dealers might take a hit.)

If the price of houses is falling, does that count as deflation? Yes, if it's new house prices that are falling, because people will postpone buying a new house if they expect new house prices to fall, which will reduce the demand for newly-produced houses. But old house prices (pre-owned?) don't matter, for the same reason that antique furniture prices don't matter.

If the price of gasoline is falling, does that count as deflation? To the extent that people postpone buying gas if they expect falling gas prices, and to the extent that gasoline is domestically-produced, the answer is yes. But if the intertemporal elasticity of demand for gas is zero the answer is no. And if the gasoline is all imported (and if we hold the exchange rate constant), the answer is again no.

If the price of new cars is falling, does this count as deflation? Yes, if people postpone buying a domestically-produced new car. But perhaps we should also look at the cross elasticity of demand for mechanics, to keep the old cars running longer.

You get the picture. Anyone with an Euler equation, some elasticity estimates, and some estimates of the extent to which the good is currently produced domestically, can keep this list going.

The key point is this: the weights on various goods which make up an index which creates a useful definition of deflation in the current debate over monetary policy with a zero lower bound will be very different from the CPI weights, because the CPI definition is designed to be useful for a very different purpose. (The best CPI weights are those designed to maximise the truth value of the sentence "If nominal income rises at the same rate as inflation, then utility is the same".)

So, with that definition of deflation in mind, do we currently have deflation? Should falling share prices be included? (And I do mean "falling", not "low", because falling share prices will have different effects on consumption and investment demand than low share prices.) What's the time period? I don't have the answers, but I think I have a way to find the answers.

posted by Nick Rowe

Comments

[Stephen Gordon]

Interesting point. I took a quick look at the CPI weights, and there doesn't appear to be a breakdown for durables. In fact, it looks as though the CPI is designed to be a measure of the prices of flows (eg: housing costs are imputed rents), so CPI may not be much use at all in this context.

[Rick]

At the risk of over-simplifying this entire post - published CPI measurements are useless. Nick just says it with a lot more smarts!

[Nick Rowe]

Rick: thanks! But to be fair to the published CPI, it might be very useful for the job it was designed to do, just not very useful for our job now.

Stephen: thanks! I'm not 100% clear on this in my mind, but I think you might have hit the empirical nail on the head. A price index of domestically-produced new consumer plus producer durables would I think come close to what we are looking for, in practical terms. (Do GDP deflators break it down that way?) A price index of current consumption flows (like the CPI) is much less useful. It's the durable goods which ought to have the high interest-elasticity of demand, right? Not the consumption flows? (I can't quite get my head clear on this.)

I realised after writing the post that I had totally ignored a second theory of why we should be worried about deflation: Irving Fisher's Debt-Deflation theory. The definition of deflation useful for a DD theory would be very different, since it's the cumulative effect of deflation on the distribution of wealth between debtors and creditors that matters, not the real interest rate effect on current demand. Must get my head around that too.

[shan]

I like the idea, but I'm skeptical of the thinking that "old house prices (pre-owned?) don't matter" for example. If existing house prices fall relative to new house prices, that too would reduce the sales of new houses. That might happen if the housing market overall falls more quickly than construction costs.

[Nick Rowe]

shan: I think you are right. But let's be more precise, because this is about the effect of the expected rate of change of prices on demand, not the effect of the level of prices on demand.

Suppose someone were just about to buy a new house. Then he suddenly changes his expectations about the price of old houses next year, expecting increased deflation, with no change to the current price of new and old houses, and no change to his expectations of deflation in new house prices. Instead of buying a new house now, as he initially planned, he might decide to wait until next year, then buy an old house. In other words, the cross-elasticity of demand between the price of future old houses (or the own real rate of interest on old houses) and current new houses is not zero. Future old houses are an (imperfect) substitute for current new houses.

This is similar to the effect I mentioned of deflation in new car prices on the demand for mechanics, except there the two goods (future new cars and current mechanics services) are complements, rather than substitutes, so it works in the opposite direction.

Dunno, but I think we should focus more on the own-elasticities rather than the cross elasticities, which could go in either direction, and maybe roughly cancel out in aggregate?

[Nick Rowe]

Oh, and if new and old houses were perfect substitutes (which is the over-simplified model I tend to have at the back of my head), then it wouldn't matter anyway, because new and old houses would always have the same price and the same rate of deflation. But their relative prices do seem to vary, so they can't be perfect substitutes. The biggest reason for this is probably that new houses are built on the edge of the city, while old houses are more central. Location matters more than the age of the house per se. Fluctuations in old house prices are mostly fluctuations in implied land values, which don't matter (except insofar as they affect the demand for new houses), because you can't produce more city centre land.